Undervalued Dividend Growth Stock of the Week: Enbridge Inc. (ENB)

In my view, people automatically assume a paycheck from a day job is a secure source of income.

But with downsizing, technological changes, and growing corporations, that just isn’t the case at all.

However, I think there’s a source of income out there that’s not only more secure, but also far better across the board.

This source of income is more diverse, more safe, more robust… and it will likely grow much faster than any paycheck can/will.

I’m speaking about dividend income.

More specifically, I’m speaking about collecting dividends from a broad portfolio of high-quality dividend growth stocks.

If you want to talk about your income being more diverse, just take a look at my real-world six-figure dividend growth stock portfolio that I built by living below my means and investing my excess capital into fantastic dividend growth stocks like those you can find on David Fish’s Dividend Champions, Contenders, and Challengers list.

My portfolio contains more than 100 of the best businesses in the world.

That’s more than 100 different sources of income for me.

Sure beats one paycheck.

In addition, most of these dividends are growing at rates that average somewhere around 7% per year.

That’s surely better than begging the boss for a 3% raise every year. Indeed, stagnating wages is a regular political topic, so I’m not making this up off the top of my head. And my real experiences in the workplace showed me that pay raises are tough to come by.

In addition, this income is more secure.

See, you can’t fire a shareholder. I can do/say whatever I want, but a company can’t just fire me.

But a worker can sure as rain be fired, as many people are unfortunately too keenly aware of.

These are just a few reasons why buying and holding high-quality dividend growth stocks is such a great way to think about income, essentially “future-proofing” oneself.

However, one shouldn’t pick random dividend growth stocks and buy them at random prices/times.

There’s a methodical and practical approach to it, of course.

One should aim to first make sure they’re investing in businesses that are within one’s circle of competence. And these businesses should have great fundamentals and durable competitive advantages.

Furthermore, and perhaps just as important, one should aim to invest when the valuation on a high-quality dividend growth stock is appealing.

But how does one know when the valuation is appealing?

Well, it’s first important to know what the value is.

See, price and value are not one and the same.

There’s a price to everything. You’ll usually find it on the price tag.

But price only tells you what something costs.

Value, though, tells you what something is actually worth.

Value tells you almost everything, while price tells you almost nothing.

Value gives context to price, advising one if the price is fair or not.

The thing about value, though, is that it’s not printed on a tag for the world to see.

As such, one needs to dig and do a little homework in order to ascertain an estimate of value.

But the work is often worth the reward, especially when it comes to dividend growth investing.

That’s because being able to buy a high-quality dividend growth stock when it’s undervalued confers a lot of benefits to the long-term investor.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return, and less risk.

That’s all relative to what the same stock would offer if it were fairly valued or overvalued.

Price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield positively impacts not only current and long-term aggregate passive income, but it also positively benefits total return.

That’s because total return is comprised of income (dividends/distributions) and capital gain.

The former benefits right off the bat.

But the latter is also given a boost via the upside that exists between the lower price paid and the higher intrinsic value of a stock.

While price and value can and often will wildly diverge in the short term, they tend to converge over the long run.

That convergence will naturally result in capital gain, which is on top of whatever organic/natural capital gain is realized as the business becomes worth more (as it sells more products and/or services, increasing its profit in the process).

Maximizing upside also simultaneously minimizes downside, limiting one’s risk.

That’s because there’s a margin of safety, or a buffer, that’s often built right in when you buy a dividend growth stock that’s undervalued, as that favorable gap between price and value also means there’s less of a possibility that the stock becomes worth less than you paid through some kind of negative event (corporate malfeasance, investor mistake, etc.).

The good news about all of this is that while price is easier ascertained than value, value is not impossible to estimate.

In fact, fellow contributor Dave Van Knapp has made the valuation process fairly simple and straightforward when it comes to dividend growth stocks, via his valuation lesson.

While having all of this information at hand is wonderful, I’m going to take it a step further by revealing and discussing a high-quality dividend growth stock that right now appears to be undervalued…

Enbridge Inc. (ENB) is an energy distribution and transportation company that owns and operates crude and natural gas pipelines across the United States and Canada.

After merging with Spectra Energy Corp. earlier this year, Enbridge is now the largest energy infrastructure company in North America.

What’s fantastic about Enbridge (and companies like it) is the fact that it doesn’t rely very much on the pricing of commodities like natural gas, which can obviously be quite volatile.

Instead, Enbridge relies on the fees it collects as commodities pass through its network of pipes, which means the company can be somewhat thought of as a “toll collector” that collects money when traffic is running across its “highways”.

And since over 90% of the company’s cash flow is supported by long-term commercial contracts, Enbridge shouldn’t suffer the same kind of shocks to cash flow that a lot of other companies in the energy space can/will.

This creates an environment of stability, which bodes well for the company’s ability to pay and increase its dividend.

That shows up when we look at the company’s dividend growth track record, which is phenomenal.

The company has paid an increasing dividend for 21 consecutive years, which obviously stretches right through the most recent shock to energy prices.

That time frame, more than two decades long, actually includes many periods of extreme volatility in commodity pricing, yet Enbridge kept right on paying and increasing its dividend.

With Spectra now under the fold, their ability to dictate fees and keep cash flow robust through volatility is even stronger.

While the length of their dividend growth track record is impressive, the rate at which they’re growing the dividend is arguably even more impressive.

The 10-year dividend growth rate stands at 12%.

While that might not seem massive at first glance, one has to keep in mind that this is a stock that also yields 4.87% right now.

Keep in mind that this yield is also more than 150 basis points higher than its five-year average, which leads back to one of the points I made earlier about undervaluation and higher yield (which then results in more current income, more aggregate income, and potentially higher total return over the long run).

It’s exceedingly rare when you find a stock yielding near 5% and growing its dividend well into the double digits.

And after merging with Spectra, Enbridge came out and stated that it expects to grow its dividend at an annual clip of between 10% and 12% through 2024, so it looks like this incredible combination of yield and dividend growth is set to continue for the foreseeable future.

While one might put the brakes on this expectation after looking at the 175% payout ratio, Enbridge’s reported EPS numbers are largely impacted by depreciation on assets that may not be depreciating at the reported rate (many of these pipelines actually become worth a lot more over time).

It works a lot like real estate; however, midstream pipeline companies, unlike REITs, don’t have an industry-approved metric that can replace EPS, so the best we can do is rely on available cash flow from operations (ACFFO) per share.

With that number coming in at $4.08 CAD for the last fiscal year (before the Spectra merger), the payout ratio is just 60%.

The dividend metrics are really fantastic here, but we still have to value the business.

In order to do so, we must have a good idea as to what kind of growth Enbridge is generating.

So we’ll next look at what the company has done over the last decade (a good proxy for the long haul) in terms of top-line and bottom-line growth, before comparing that to a near-term forecast for profit growth.

By looking at the past and future in this manner, blending the two together should give us an idea as to what kind overall of growth the company is producing.

Since this is a Canadian company, we’ll be using Canadian dollars.

Enbridge grew its revenue from $11.919 billion CAD to $34.560 billion CAD from fiscal years 2007 to 2016. That’s a compound annual growth rate of 12.56%.

That’s well in excess of the mid-single-digit revenue growth I usually look for when dealing with fairly mature companies.

However, midstream pipelines share something else in common with REITs: they often issue debt and equity to finance growth.

Enbridge’s outstanding share count has grown by almost 30% over the last decade, which affects the company’s profit growth on a per-share basis.

But it’s looking at numbers when normalized for the expansion in the outstanding share count that gives us a true picture of Enbridge’s actual growth.

The company grew its EPS from $0.97 CAD to $1.93 CAD over this same 10-year stretch, which is a CAGR of 7.94%.

Still a fantastic result here, which happens to run through a time period that includes the financial crisis and more recent massive drop in energy commodity prices.

Looking forward, CFRA is calling for 10% compound annual growth in Enbridge’s EPS over the next three years, supported by the larger and more balanced platform that now exists after the Spectra merger.

This would support dividend growth that’s at least in kind, which seems to suggest that management’s call for 10% to 12% dividend growth for the next seven years is reasonable.

The company’s balance sheet is stressed in absolute terms, although this is largely due to the fact that the company operates a capital-intensive business model that’s asset heavy. Overall, they’re in line for the industry, meaning the balance sheet is relatively acceptable.

The long-term debt/equity ratio is 1.71, while the interest coverage ratio is under 3.

Profitability is also what you’d expect for a midstream pipeline company.

Over the last five years, Enbridge has averaged net margin of 3.12% and return on equity of 11.95%.

This is a company providing necessary infrastructure, with very little reliance on the underlying pricing of the commodities that pass through its pipelines.

That structure bodes well for the dividend and the growth of the dividend.

But the stock isn’t worth paying any price for.

That leads us to wonder…

Is the valuation reasonable here?

The P/E ratio is 35.95 right now. That’s obviously high relative to the broader market (and pretty high in absolute terms), although it’s well below the stock’s five-year average P/E ratio of 65.6. The problem, as noted earlier, is that the company’s reported EPS is skewed. Using the midpoint of FY 2017 ACFFO guidance, the P/ACFFO is sitting at 10.92, which is very attractive. Moreover, the yield, as shown above, is significantly higher than its recent historical average.

So the stock does look cheap here, but how cheap might it be?

I valued shares using a dividend discount model analysis.

I factored in a 9% discount rate (due to the high yield) and a long-term dividend growth rate of 5.5%.

That long-term dividend growth rate is approximately half of what the company is guiding for over the next seven years, so I’m building in a pretty heavy margin of safety here. But I usually like to err on the side of caution, as this is looking out over the very long haul. Moreover, that dividend growth is predicated on the continuation of many growth projects.

The DDM analysis gives me a fair value of $60.29.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

My analysis concludes that the stock is very cheap here, as evidenced by the P/E ratio that’s almost half its five-year average (comparing apples to apples). However, my DDM analysis admittedly favors the high yield here. As such, we’ll compare my valuation to what two professional stock analyst firms came up with.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates ENB as a 3-star stock, with a fair value estimate of $43.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates ENB as a 4-star “BUY”, with a fair value calculation of $39.40.

It’s interesting that the latter firm recommends buying a stock that they feel is slightly overvalued, but averaging the three numbers out gives us a final valuation of $47.56. That would indicate the stock is potentially 17% undervalued right now.

Bottom line: Enbridge Inc. (ENB) is the largest energy infrastructure company in North America, with most of its cash flow supported by long-term commercial agreements that don’t depend on commodity pricing. This stable outlook means the dividend should continue to flow and grow. With a yield near 5% and double-digit dividend growth, along with the potential for 17% upside, this stock currently offers one of the most outstanding combinations of income and upside in the dividend growth stock universe. It deserves strong consideration as a long-term investment candidate.

— Jason Fieber

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